FWIW # 37 - Four Major Risks

It’s been a while since the last FWIW, primarily because I’ve been dumbfounded by the surreal events taking place. I’m not speaking about the stock market and its rise this year. That’s the only event that makes sense—but not for the reasons the business media and analysts opine. I’ll come back to the markets later in this discussion. Let’s start with the third (there are multiple) truly big risk to your portfolio and the investment markets: the blatant partisan bias in the persecution of Donald Trump.

The problem with Trump

It needs to be clear: I voted for Trump twice, in 2016 and 2020, but I wouldn’t vote for him again for any political office. Not because of what the Democrats called “insurrection” on January 6. (How do you have an insurrection when none of the insurrectionists had guns, knives, or other weapons to overcome the weapons of the capitol police?) When I voted for Donald Trump the first time, it was because he clearly pledged to help the middle and working classes of this country. This broad segment of the population, the bedrock of our country, has been trampled on by the elite globalists for 30 years, eroding their lives and well-being through globalist domestic and foreign policies that hinder working people to the point it took $334.69 in 2020 to buy the same goods they could purchase for $100 in 1980. Notice, this egregious inflation was before the surge of inflation after the pandemic. Then came the pandemic. Trump made some incredibly strong decisions based on advice from the government’s “experts,” but his ego derailed what should have been his shining managerial hour. Instead of allowing the experts to communicate needed and wanted information to the public, he took center stage each day and let an ignorant and partisan media goad his ego into expounding on unnecessary and irrelevant issues.

The resistance to the legitimate election in 2016 and Trump’s emotional volatility created turmoil in the country for four years.

It is my sense that Trump’s current popularity stems from the elitist persecution of him. The political establishment knows the danger of a tough populist leader calling them to task for their decades-long subjugation of the middle and working class. When the current president’s scandal-ridden family affairs are brushed aside, impervious to consequences, the glaring difference in the definition of justice causes many to rally to the cause of the persecuted and to lose faith in our government.

I don’t know what is going to happen to Donald Trump in the many judicial proceedings facing him. He does not deserve much of what he is going through—but he must answer for some of his actions. What I do know is this: Trump is a flawed character who has insight into the plight of the middle class and the working class. At the same time, he has alienated enough of his supporters, who were disappointed by his egotistical chaos and volatility, that he will never get enough votes in a general election to win. If the partisan persecutions were stopped, Trump might not even win the Republican nomination. What the Democrats and elitists don’t recognize is that Trump’s perspective is legitimate and stronger than one person. The next torchbearer of the working and middle classes’ anger, disappointment, and fear will be just as tough but more emotionally disciplined and less egotistical. That candidate will channel and lead working- and middle-class emotions to change the direction of the country. The question is what direction, and that’s the danger to your portfolio and the investment markets.

A bigger problem than Trump

The favorite refrain from the liberal media and socialists about Trump or some Supreme Court ruling is they are a “threat to democracy.” However, the one true threat to our democracy is democracy itself as practiced today. Let me explain.

Every citizen, except for felons in some states, has the right to vote. It doesn’t matter if they are productive or mentally competent and aware. That’s appropriate and the way the Constitution is written. Partisan gerrymandering has been ruled unconstitutional by the Supreme Court; however, controlling gerrymandering was left up to Congress and/or the state legislatures. Racial gerrymandering, dictated by the Federal government, designed to give minorities more clout in electing officials is acceptable. What we have achieved through this exception and plain political underhandedness are congressional districts and state legislatures that are solidly controlled by one party or the other, leading to the severe partisanship demonstrated today.

While gerrymandering is bad, what is worse is the voters’ willingness to ignore the qualifications of the people running for office. The country elects the most charismatic leader, smoothest talker, or biggest liar. The strangest aspect of our present political environment is the fact that the internet and all the available big data on the net could, if utilized, shed light on the true character and political thoughts of candidates, but these are ignored. All the nongovernmental “think” organizations have ignored the opportunity to be leaders in bringing truth and transparency to the process of building good government. The latest statistic I have heard is that 47% of the population is dependent on the federal government in one way or another. If that’s true, and I haven’t tried to verify it, we are coming close to the point where the productive class, who is footing the bill for the social safety nets that Washington continues expanding, stops believing this country is still the place where everyone is treated equally. That’s the second most important threat to democracy and your portfolio. Now to the most important threat.

The biggest problem

The investment markets, as they usually do, have ignored all the political nonsense. It’s important to understand that investment markets focus on unemotional factors over the long term. As I’ve said in my book 19 Rules for Getting Rich and Staying Rich Despite Wall Street, the current markets have been turned into casinos for the benefit of Wall Street and their short-term trading partners. The public and many institutional investors have heard and followed the siren song of quick profits from trading. True investors understand this constant flurry of trading and its swings of fear and greed can and does create long-term opportunities for patient investors who want to get rich and stay rich.

That thought brings up the real reason the market has rebounded from the selloff last year. Last week we received a CPI number that showed headline inflation was up 3.7% and core inflation was up 4.3% year-to-year. Some analysts believe these numbers are good and indicate the Fed won’t raise rates again. But what do the numbers really mean? If these levels persist for 10 years, they mean your net worth and your income’s purchasing power will decline between 37% and 43%. Think this is a scary number? Look at the cumulative change in purchasing power I mentioned above, from 1980–2020. Looking at the current change in the CPI from January 2020 to last month is even more scary. What you could buy with $100 in January 2020 took $181.10 in August 2023, and the CPI is still running at 3.7%! Non-thinkers, and those who fail to understand inflation is a deliberate move by the political establishment to offset its questionable fiscal management, applaud the claim that inflation is down from its peak when it is actually still destroying working people’s net worth . Without some mechanism to offset this deliberate devaluation of your money, you and your family will face the same crisis that the 45% of Americans who don’t own stocks are grappling with today. Only the unthinking can say that inflation is satisfactory. Inflation will be the spark that ignites the inferno of built-up anger and frustration at the elite political and business leaders as the population loses confidence in political institutions. Inflation is never an accident or unintentional. Inflation will stay elevated until and unless the Federal Reserve changes its policy for managing the money supply.

Downstream effects and how to navigate them

What to do as investors is the question as we see the stock market rise and interest rates approach a normal level. The quandary is the amount of leverage in the investment markets causing substantial overvaluation. Let me explain.

The investment markets are in a high-risk state. Let’s look first at the fixed-income markets. Traders continue to believe the Fed will lower interest rates in the relatively short term, and consequently the interest rate yield curve is out of kilter. Long rates should be higher than short rates, and the opposite is the case today. In addition, there is high leverage in the US Treasury market because hedge funds are attempting to make the interest–income difference between the actual treasury securities and the treasury futures market. This leverage is a dangerous component of the markets because the supply and demand factors for the futures markets are different from the actual treasury securities’ supply and demand factors. The amount of leverage used to hold these “basis” trades is more than 55 to 1, a staggering potential problem.

Inflation’s historical price action has taken the form of waves. A rising annual rate goes to a peak, then inflation falls to a lower level, but not to the starting point, followed by another rise to a potentially higher peak. If that pattern presents itself this time, the leverage in fixed-income markets could force liquidation and losses at the banks and private lenders funding the speculation.

A forced liquidation in the fixed-income markets generally leads to aggressive selling in the stock markets to offset the losses experienced in fixed-income markets. There is a saying in the investment markets: When in trouble, speculators sell what they can, not necessarily what they should. In a crisis, public stock markets are the place speculators go to raise money.

The fact that various indices are heavily weighted toward a few stocks and one economic sector (technology) causes an imbalance if there is a forced liquidation. Our work on stock valuations from an investor’s perspective indicates the markets are highly vulnerable if sentiment changes. The actual saving grace for stock price levels is the inflation we have experienced since 2020 and the inflation we will experience, no matter what the Fed does, over the next five years. Stock prices are partly reflecting this inflation wave. What can bring stock prices down temporarily is a deleveraging in both the fixed-income and stock markets. It can and likely will happen quickly. It is critical to own companies that have strong balance sheets and economic clout in their markets. Decide now what you want to add to your portfolio in a sharp market selloff.

There is a fourth disturbing trend in the investment markets. Because of a new fad (idea sold by Wall Street to institutional investors), the major move of institutional money today is toward non-public investments. These investments lock in investors for periods of time, such as 7 to 20 years. There is no market for these investments, and consequently the prices of the securities are determined by what are politely called educated guesses (computer models). The thought pushed by Wall Street is that real money is made by holding private investments for long periods. (Never mind that similar results can be obtained in the public markets as discussed in my book.) Wall Street says this long-term perspective is not possible in the public markets, nor can prices in the public markets be as attractive as they can in the private markets.

There are multiple reasons that thinking is illogical. The fact is the only reason a private investment may be cheaper than a public investment is because the illiquidity risk demands a higher return. The investment itself is not necessarily better than an investment found in a public market. One clear example is a company that had an IPO yesterday after having a private market funding event last year with a valuation of $39 billion. Its initial public value was priced at approximately $10 billion, meaning the institutional investors (some of which may have been mutual fund managers and pension funds) who invested last year have lost substantial money.

The trend toward private-market investing will likely cause greater volatility in the public markets as less money is allocated to public markets. That increased volatility will work to the benefit of long-term investors. The tragedy is the unsuspecting pensioners and fund holders don’t realize what risk is being taken with their pension money or net worth. Why a greater risk? Past crises have shown that some institutional investors, when a crisis occurs, are forced to sell these illiquid private investments at deep discounts and losses. Finally, being private, the amount of leverage in these investments can be substantial, leading to greater fragility of the investment and the markets.

Stay invested and be prepared for a sharp deleveraging event to create opportunities.